How is regulatory stress-testing shaping the future for banks?

The landscape

Out of the shortcomings exposed in banks' traditional risk management processes during the recent global financial crisis, comes the critical need for improvement. Although the list of needed repairs is long and growing, one particular high-profile risk management requirement is subject to additional regulatory burdens and wider scrutiny: enterprise stress-testing. Specifically, it is stress-testing of future capital adequacy and often goes under the category of "forward-looking" risk assessment.

The best known example is the Comprehensive Capital Analysis and Review (CCAR) requirement in the US. The reason given by the US Federal Reserve for this program is to "...ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks and sufficient capital to continue operations throughout times of economic and financial stress." Should the US Federal Reserve find issues, it can act, and this could lead to the
potential rejection of capital plans including dividends.

The CCAR process requires both banks and the regulator to analyze bank balance sheets and exposures in a way that is far more detailed and prescriptive than had been undertaken in other jurisdictions. This initiative is moving the industry away from general statements of expectations and basic top-down testing into more involved and invasive analysis. In particular, the European Central Bank (ECB) and Bank of England (BoE) are looking to learn from the US Fed with their planned stress-testing programs and they are likely to issue similar requirements.